Passive Investing Trends: Chasing Returns or Investing on Merit? By Jim Wiandt October 5, 2001

Index funds are on the rise. Assets flowing into index mutual funds have been rapidly growing both in absolute terms and relative to inflows into actively-managed funds. The million-dollar question is whether these inflows have resulted from investors seeing the light and investing in the passive funds on merit, or simply chasing returns? Only recently has the body of data become sufficient to properly analyze the question. Given the implicit cautiousness of index funds, it is both ironic and telling that index funds have boomed relative to active funds during the roll-out-the-barrels bull market of recent years.

So what is ironic, and how is it telling? The ironic part is that ostensibly one would think that a penny-pinching index strategy that forgoes any bet and plays every number on the roulette wheel for even money at minimum cost would appeal in down markets when every basis point counts. Telling is the fact that return-chasing money moved into index funds. Why did it move? By and large index fund returns throttle the active competition, particularly in bull markets. When the market is steaming ahead, every dollar not invested in the market by a fund is a cash drag against returns. That, coupled with the ever-present reality that transaction and management costs go up with, well, the additional transactions and management required by active management, led to significant outperformance of active funds by the market, as represented by the Wilshire 5000 as you'll see later in this article.

The data seems to indicate that this is what has driven the indexing boom. Quite simply, over the time period of 1990-2000, inflows into mutual fund generally reached their highest levels, both in absolute terms and relative to total mutual fund inflows, when the markets were doing best. The chart and table below below examine Financial Research Corporation (FRC) and Investment Company Institute (ICI) data and present index fund inflow data both in absolute terms and as a percentage of total.

Year	Total Equity Fund Inflow $Billions	Equity Index Fund Inflows $ Billions	Index as Percentage of Total Inflow	Wilshire 5000 Return %
1989	5.8	.9	15.5%	29.17%
1990	12.9	1.8	14.0%	-6.18%
1991	39.9	3.5	8.8%	34.21%
1992	79.0	5.4	6.8%	8.97%
1993	127.3	6.9	5.4%	11.28%
1994	114.5	3.9	3.4%	-0.07%
1995	124.4	10.3	8.3%	36.45%
1996	217.0	22.8	10.5%	21.2%
1997	227.1	30.7	13.5%	31.29%
1998	157	37.8	24.1%	23.43%
1999	187.7	54.3	28.9%	23.56%
2000	309.6	21.63	7.0%	-10.9%
Average	133.5	16.7	12.2%	16.87%

The Big Picture

While the first retail index mutual fund, the Vanguard 500, was launched in 1976, according to Financial Research Corporation data, inflows into index funds only topped $1 billion in 1989. Of course the trickle soon became a deluge, though, and by April of 2000, right in the vicinity of both the broad stock market and technology sector's nexis, the Vanguard 500 assumed the mantle of largest mutual fund by capitalization. Why? Framed in that way, the question seems to answer itself - assets peak just as returns peak.

A number of issues bear examination, however. How have relative inflows looked in up and down markets? When have inflows been hit the hardest relative to total mutual fund inflows? Here, of course is where we find our Occam's Razor. When are index fund inflows at their highest level relative to all funds and why? When is their fall in inflow relative to all funds greatest and again why? For purposes of our analysis, and in the previous table, we examine the 10-year time period of 1991 - 2001. Using Investment Company Institute (ICI) data for the total universe and FRC data to examine index fund inflows we can examine the facts:

• The all-time high for inflows into index funds, domestic equity funds, and the Vanguard 500 in absolute and relative terms occurred in the first quarter of 1999 - the last year of the freight train bull market that steamed through the five years from 1995-1999.
• In 2000, the first losing year for the S&P 500 since 1990, equity index inflows fell 63% off the record year, amounting to just 7% of equity mutual fund inflows (down from 29% in 1999). This abysmal trend continued into the first quarter of 2001 with active managers, finally getting a chance to harvest the fruits of a merciful bear market, banging the drums. Q1 index fund inflows were at their lowest level since Q3 1995, when the magical run got underway.
• Pre-bull, the data is somewhat less conclusive. In fact, though index inflows more than doubled from 1990, when the market was down, to 1991 when it returned over 30%, index fund inflows as a percentage of total fund inflow actually decreased, from 4.5% to 3.9%.
• In a middling market, that percentage continued to decline nominally until it reached 3.4% of the total in 1993. In the faltering market of 1994, index fund inflow increased to 5% of the total inflows fell by more than 50%. More telling though, is the fact that in the weaker 1990-1994 market, equity index inflows fell steadily from 14.0%, 9.9%, 6.8%, 5.4% to 3.4% in the down market of 1994.
• Welcome 1995: equity index fund inflows parallel the rocketing market, amounting to 8.3%, 10.5%, 13.5%, 24.2% and 29% of equity inflows from 1995-1999.

The Ultimate Oranges to Oranges Comparison

In terms of the sheer amount of inflow and returns data available, there is no better comparison to examine than the Vanguard 500 (the oldest retail index fund) and the S&P 500. Using FRC inflow data for the Vanguard 500 fund and Ibbotson Yearbook data for S&P 500 annual returns and 5-year trailing returns we can examine 15 years of inflow and returns data for a single index/ index fund.

Year	Vanguard 500 Inflow in $MM	Inflow % Change from Prev Yr	S&P 500 Total Returns
1986	65.4	—	18.47
1987	286.1	337.5	5.23
1988	105.5	-63.1	16.81
1989	398.0	277.3	31.49
1990	272.9	-31.4	-3.17
1991	1266.6	364.1	30.55
1992	2102.2	66.0	7.67
1993	544.8	-74.1	9.99
1994	776.9	42.6	1.31
1995	3,682.7	374.0	37.43
1996	5,693.7	54.6	23.07
1997	5,170.4	-9.2	33.36
1998	6,543.5	26.6	28.58
1999	8,676.0	32.6	21.04
2000	1,486.7	-82.9	-9.11

As might be expected, the relationship of Vanguard 500 inflows relative to the market is quite similar to that experienced by equity index funds relative to equity returns across the time period. With the exception of anomalies in 1987-1988 and 1997, inflows generally trace market direction. Rearview mirror investing trumps reversion-to-the-mean logic with the Vanguard 500 just as surely as it does with Janus funds or any other investment that sees investors chasing returns. The year of largest inflow was promptly followed by the worst returning year of the time period.

Active vs. Passive Redux

Of course the premise that the returns-chasers moved proportionately toward index funds in up years is supported by the fact that index funds outpace actively managed funds in bull markets. Correspondingly, the decrease in index fund inflow share in down years points to the tail-chasing move toward active funds in those years.

It is easy enough for retail investors to buy cheap access to the total stock market. And getting market returns is no fantasy, either. The Vanguard Total Stock Market Index fund has actually outpaced the Wilshire 5000 by 5 basis points (13.32 to 13.27) over the past 5 years annualized. Retail investors in VTI, the new Vanguard total market ETF, might expect to do even better, as its expense ratio of 0.15% annually (15 basis points or BP), down from the already slim 20 BP of the fund's investor share class. Compare these expense ratios to those of active funds and the reason most active funds have underperformed the market is no secret. Always an apples to apples man myself, I took the entire field of mutual funds listed on Morningstar, winnowed them down to just active domestic stock funds (there are 6658 on the list) and found an average expense ratio of 1.45%. And of course the total return figures are not even adjusted for load, of which more than half of the funds on the list are burdened. The bust has been a boon to active funds hoping to make a comeback versus index funds.

Last year, along with those falling index funds inflows, actively managed funds trumped Wilshire 5000 returns in a romp. Of the 5509 actively managed funds for which Morningstar has a full year of data, 4123 funds beat Wilshire 5000 returns. That's a cool 75%. Returns across the bull 1990s however, were not so pretty. Even absorbing the kindly bust period of 2000 and early 2001, only 35% of the actively managed funds managed to beat the Wilshire 5000 in 5-year total annualized returns…just 32% over 10 years.

That then, leads us to the following conclusions:

• Index fund inflows have boomed in recent years with a rising market.
• Index funds have generally performed better when the market has been up, and worse when the market has been down.
• The periods of time when index fund inflows were greatest relative to general mutual fund inflows generally occurred when the market was up.
• The periods of time when index fund inflows have tailed off relative to all mutual funds have generally occurred when market has struggled.
• There is nothing contradictory between returns-chasing and investing on the merit of index funds, because their higher average returns relative to the field, particularly in bull markets, are their merit.

This article was originally printed in the 3rd Quarter issue of the Dow Jones Journal of Index Issues, which will be edited by Jim Wiandt and produced in conjuction with Financial Advisor magazine from the 4th Quarter of 2001.